Smith & Wesson to outperform Ruger; Phone survey shows market share redistribution

3/31/2014

Smith & Wesson Holding Co. (SWHC) - $14.62 Sturm Ruger & Co. (RGR) - $59.80 Cabelas Inc. (CAB) - $65.51

Why Read?

Since Obamas election and the Sandy Hook shooting, firearm sales have been on a tear, with NICS checks rising +8% in 2013 and +53% since Obama entered office. With both SWHC and RGR having greater than 30% short interest, the market believes the trend is beginning to reverse. We believe SWHC is taking share from RGR and will continue to see strong sales for the next 12-18 months. _________________________________________________________________________________________________________ NICS checks decreasing but handguns sales still strong: For the twelve months ending February

2014, total NICS checks dropped -1% vs. the comparable twelve months ending February 2013. Despite the overall decrease, we believe handgun and concealed firearm unit sales have remained positive. California, Texas, Illinois, New Jersey, and Massachusetts all posted strong positive sales. We believe that because these states have large urban populations, sales mix trends towards handguns versus long guns.

Share redistribution: During SWHCs most recent quarter ending Jan. 31, 2014, firearm revenue

(ex discontinued Walther sales) increased +17% while NICS checks decreased -24%. During RGRs most recent quarter ending Dec. 31, 2013, firearm sales increased +30% while NICS checks decreased -13%. Adding back the decrease in NICS checks, SWHC posted a +41% stack while RGR posted a +43% stack. Most importantly SWHC handgun sales sequentially accelerated from +27% in 2Q13 to +30% in 3Q13.

Handgun product cycles: Handguns sell in 12-18 month cycles, where one brand will command

the marketplace until the next hot handgun hits the market and enters full production. RGR was the first to command the concealed carry/womens market with their LCP380. SWHC countered with their M&P Shield and Bodyguard lines, which have quickly become the most popular selling concealed carry handguns. The Glock 42, a single stack .380 concealed carry pistol is expected to be the next hot gun but we do not expect production and sales of the Glock 42 to hit its full stride for another 12-18 months. Until then we expect SWHC to dominate the concealed carry handgun market. Of the 34 sporting goods stores we surveyed, 67% said the SWHC M&P Shield was the best selling concealed carry handgun.

Distribution still tight: Of the 34 sporting goods stores we surveyed, 92% had the Ruger LCP380

in stock, 79% had the M&P Bodyguard and Shield lines, and only 4% had the Glock 42. Many stores also complained about the difficulty of getting J-frame SWHC revolvers, another popular model for concealed carry. SWHC is increasing production in this line. We expect this to benefit sales going forward.

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NICS checks decreasing but handgun sales still strong NICS Checks as percentage of state population

NICS checks as a percentage of state population has been growing in many key states, such as Illinois, North Carolina, Utah, Alabama, Connecticut, and Massachusetts. We believe much of this increase is due to increased concealed carry handgun sales and the sharp rise in female first time handgun buyers. According to the New York Times, from 2001-2011, female gun ownership has increased +51.5% for target shooting and +41.8% for hunting.

We have also included some anecdotal evidence collected during our sporting goods store handgun survey:

Regarding .380s "Women are buying the stew out of them" - Basspro, Prattville, AL Weve sold more guns to ladies over the past 18 months than any other demographic- Basspro, Destin FL

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NICS Checks: 12 months ending Feb. 2014 vs. 12 months ending Feb. 2013.

Although NICS checks have begun to decline, we still observe strength in states with large urban populations where we believe handgun sales are still driving growth. States such as California, Texas, Illinois, Indiana, New Jersey, Connecticut and Massachusetts all posted strong positive NICS checks in the 12 months ending February 2014 vs. the comparable period LY.

Sequential growth: Trailing 12 months ending Feb. 2014 vs. trailing 12 months ending Jan. 2014.

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SWHC handguns taking share from RGR:

West/Midwest In stock? Ruger

LCP380

SWHC M&P Shield

SWHC M&P

Bodyguard Glock 42 Best seller Grandeville, Michigan Cabela's yes no no no Shield

Council Bluffs, Iowa BassPro no no no no n/a

Wheeling, West Virginia Cabela's yes yes yes yes Shield

Dundee, Michigan Cabela's yes yes yes no Shield

Hammond, Indiana Cabela's no no no no Shield

Las Vegas, Nevada BassPro no yes yes no Shield

Cheyenne, Wyoming Sportsman's yes no yes no Shield

Grand Junction, Colorado Cabela's yes yes yes no Glock 42

Mesa, Arizona BassPro no no no no Ruger LCP380/Shield

Rancho Cucamonga, California BassPro no no no no n/a

Lone Tree, Colorado Cabela's yes yes yes no Ruger LCP380

Kansas City, Kansas Cabela's yes yes yes no Shield

Post Falls, Idaho Cabela's yes yes yes no Springfield XDS

Idaho Falls, Idaho Sportsman's yes no no no Ruger LCP380

Rapid City, South Dakota Cabela's yes yes yes no Shield

Ashwaubenon, Wisconsin Cabela's yes yes yes no Shield

Sub Total In stock? 69% 56% 63% 6% Shield - 64%

East/Texas In stock? Ruger

380

SWHC M&P Shield

SWHC M&P

Bodyguard Glock 42 Best seller Tallahassee, Florida BassPro yes no no no Ruger LCP380

Lawrenceville (Atlanta), Georgia BassPro no yes no no Shield/Glock

Ashland (Richmond), Virginia BassPro no yes yes no Shield/Springfield XDS

Scarborough, Maine Cabela's no yes yes no Shield/Ruger LCP380

Columbia, South Carolina Sportsman's yes no no no Shield/Springfield XDS

Chattanooga, Tennessee Sportsman's yes no yes no Shield

Buda, Texas Cabela's yes yes yes no Shield

Allen, Texas Cabela's yes yes yes no Shield

Gonzales, Louisiana Cabela's yes yes yes no Shield

Destin, Florida BassPro yes yes yes no n/a

Prattville (Montgomery), Alabama BassPro yes no no no Ruger LCP380

Orlando, Florida BassPro no no no no Shield Bodyguard

Macon, Georgia BassPro yes yes yes no Ruger LCP380

Myrtle Beach, South Carolina BassPro no no no no SWHC revolver

Concord (Charlotte), North Carolina BassPro yes yes yes no Shield

Hampton, Virginia BassPro yes no no no n/a

Palm Bay, Florida BassPro no yes no no Shield

Nashville, Tennessee BassPro no no no no Ruger LCP380/Shield Bodyguard

Sub Total In stock? 61% 56% 50% 0% Shield - 69%

Total 92% 79% 79% 4% Shield - 67%

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Handgun product cycles:

Handguns typically sell in 12-18month cycles. Most new products are released to buyers at the annual SHOT show in January. We expect the M&P shield will continue to dominate the concealed carry handgun market until the Glock 42 fully enters distribution and production 12-18 months from now. Of the 34 sporting goods stores we surveyed, 67% said the SWHC M&P Shield was the best selling concealed carry handgun.

Its kinda like a fish when theyre nibblingyou get a few on the market and see if theyre nibbling and then [if they are] theyll release a huge swarm of them and itll be like catching the next big fish. BassPro, Council Bluffs, IW

We have observed a strong preference for single stack versus double stack pistols for concealed carry usage. The single stack pistols provide a much slimmer profile, making it easier to keep in your waistband, where the majority of concealed firearms are carried if on the body.

Additionally, we have observed a strong demand for SWHC J-frame revolvers. The company is increasing production of this model and was often cited by gun stores as very difficult to order.

Regarding M&P Shields: "Last week we got ten in on Thursday and they were all gone by Friday." - Sportsman's Warehouse, Chattanooga, Tennessee

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Financial Analysis: As of March 14th, SWHC has a 39% short interest while RGR has a 32% short interest. Clearly many market participants believe gun sales will decrease. We do not disagree with that. But instead of every firearm manufacturer being hurt equally, we believe there will be winners and losers. We believe SWHC will continue to take market share in the concealed carry and self-defense handgun segment. Its M&P Shield and Bodyguard lines have dominated the market during the last year and will continue to do so until the Glock 42s production ramps. We believe SWHC will increase its sales +4.5% in FY14 to $647.7m versus a consensus of $620.4m, driven by a +10% increase in handgun sales, -10% decrease in other firearms and +5% increase in accessories. With the acquisition of Tri Town Precision, their polymer supplier used in manufacturing black guns, we believe that GPM will expand +100 Bps to 43% for FY14, operating margins will expand +278 Bps to ~26.7%, and the company will generate ~$200.8m in EBITDA and FCF of $95.8m as it looks to rebuild inventory levels to normal levels. SWHC is currently trading at an EV of 1.4x FY14E sales and 7.3x FY14E EPS of $2.02 (consensus $1.44). $0.12 of our increase in EPS is from an additional 4.5m in shares to be repurchased over the next year. SWHC is also trading at an EV/EBITDA ratio of 4.4x FY14E EBITDA of $200.1m. With such a high short interest, and ample cash flow, we expect shorts will continue to get squeezed as SWHC sales defy the overall mean revision in the firearms market. We believe RGR will continue to lose market share to higher quality concealed carry firearms like the M&P Shield and Glock 42. We believe RGR sales will drop -8.1% in FY14 to $633.4m versus a consensus of $599.3m, driven by a -15% drop in handgun sales, flat long gun sales, and +10% increase in accessories. We expect GPM to remain stable at ~37.5% and OPM to contract -220Bps to ~23% based on increased operating spending to bring new production facilities online. We expect the company to generate $175.0m in EBITDA and FCF of $65.0m as it looks to rebuild inventory levels, a theme observed across the industry.

RGR is currently trading at an EV of 1.7x FY14E sales and 12.2x FY14E EPS of $4.85 (consensus $4.18). RGR is also trading at an EV/EBITDA ratio of 6.2x FY14E EBITDA of $175.0m. In an effort to reduce exposure to broader trading based solely on NICS and industry gun sales, we believe pairing SWHC/RGR is an excellent opportunity to isolate alpha as handgun market share is redistributed between the two companies.

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